Creating the net investment income tax regulations: A conversation with David Kirk

A principal author discusses the complex task of writing the rules, including the role played by CPAs.

From 2008 until 2014, David H. Kirk, one of the two principal authors
of the proposed and final net investment income tax regulations (T.D.
9644, REG-130843-13, and REG-130507-11), was an attorney in the
Passthroughs and Special Industries Division of the Office of Chief
Counsel of the IRS.

The net investment income tax, enacted by the Health Care and
Education Reconciliation Act of 2010, P.L. 111-152, imposes a tax on
individuals in tax years beginning after Dec. 31, 2012, of 3.8% of the
lesser of net investment income for the year or the amount by which
modified adjusted gross income (AGI) exceeds a threshold amount of
$200,000 for a single individual or $250,000 for a married couple
filing jointly. For estates and trusts, the tax is 3.8% of the lesser
of undistributed net investment income or AGI over the dollar amount
at which the highest trust and estate tax bracket begins (for 2014,
$12,150).

I recently interviewed Kirk about the regulations’ creation and asked
him to address some technical questions the new tax poses. Following
is an edited transcript of the interview.

Give us a short overview of the net investment income
tax.

Kirk: The net investment income tax was created to
generate approximately half the revenue needed for the Affordable Care
Act [Patient Protection and Affordable Care Act, P.L. 111-148]. I
believe the IRS is projecting approximately 3 million taxpayers are
subject to this tax, and it will only go up from 2013, partly because
the thresholds are not indexed for inflation. Also, a lot of people
have capital losses that were generated during the Great Recession
that are finally burning off, and that will cause them to start having
net investment income subject to the tax.

When did the IRS start working on the regulations? I’ve heard
some very big numbers on the number of people who contributed and
helped you develop these regulations.

Kirk: I remember picking up the regulations in early
November 2010. One morning I just started doing a spreadsheet of all
sorts of open items and which divisions or which Code sections it
would turn on that would involve other attorneys within the Chief
Counsel’s Office—about 50 attorneys, and over on the Treasury side,
maybe 15 individuals. I came up with 35 questions that we’d need to
answer to make it work—thorny issues or ambiguities that were
important to resolve. All the divisions got their input into what were
the major things that needed to be tackled and judgment calls that
needed to be made. And, generally, I would have to say, the Chief
Counsel’s Office and the IRS are not built to do something like that,
where you had every single division feeding in. And so the management
of the teams in the process was probably one of the most
time-consuming pieces, which is why it took two years, two weeks, and
two days from when we first picked up the statute until the original
proposed regulations came out in late November 2012.

How were the public and the AICPA involved in the development
of these regulations?

Kirk: One of the things that we tried to do was to be
open and transparent and try to get the word out. There was the normal
comment period required in the Administrative Procedure Act; we gave
90 days to comment. The larger organizations—the New York State Bar,
American Bar Association, the AICPA—began to appreciate in the
development of the comment letters how complicated it is, how many
tentacles it has into all the different subject matter areas. From the
CPA perspective, we went on the road, as you know, as our own public
relations stint. I think in 2013 I did 30 different panels and
presentations—speeches around the country, trying to basically show
that this is much more complicated than a two-page statute might
appear to be. What they saw was that once you started, it was like
peeling an onion, and it got more and more complicated as you peeled
off each little piece.

The AICPA provided a perspective of on-the-ground tax practitioners,
the ones that are doing the forms and are struggling with this during
filing season. We needed that perspective and those issues that they
bring in to us, either informally or formally via comment letters.

What do you think are the most challenging aspects of all the
new rules, the instructions, the forms, the regulations, and the statutes?

Kirk: For CPAs, the most challenging aspect is the
sheer volume of rules associated with a tax that is relatively small
on an individual taxpayer basis. Now, of course, there are the people
that have the $60 million AGIs, although they’re few and far between.
The sheer amount of information that CPAs need to know just to fill
out the Form 8960 [Net Investment Income Tax—Individuals, Estates,
and Trusts] is overwhelming. How can the CPA prepare the tax
return with the Form 8960 and not spend an inordinate amount of time
and additional cost for the client?

When it comes to technical matters, a challenge is the interaction
between Sec. 1411 as a revenue-generating statute with Sec. 469, which
was built in 1986 and over the following 10 years or so to identify
loss-generating activities. When you put these two systems together,
they’re like two tectonic plates crashing together, such that they
produce very strange outcomes, something that CPAs are going to have
to get their arms around.

Would you say more about that intersection point?

Kirk: Well, we have a passive loss system that was
created 25 years ago to identify loss-generating activities. And
loss-generating activities sometimes were able to be structured as
income-generating activities. And what the regulations did under Sec.
469 was to attempt to strip out from these passive activities certain
types of activities that would cloud the overall picture of what the
statute was trying to get at. It did this with the idea of trying to
isolate these generated losses to properly suspend them. Forward 25
years, we have Sec. 1411 coming in, and what it does is look to Sec.
469 to identify passive income generators. You have 25 years of
history of the IRS trying to compartmentalize things, to make them
nonpassive in order for them to not mess up the passive activity
rules, but then you have Sec. 1411 coming in and trying to identify
passive income, and when you put them together, it creates very
strange and very complicated offspring.

Let’s transition over to rental real estate. I understand that
if I am passive, that will be subject to the net investment income
tax. I also understand that there’s a small group of people who will
be in the trade or business of real estate who will not be subject
to the tax. But then, there’s the rest of America that’s in the
middle. Maybe they’re already real estate professionals under Sec.
469, but under the Sec. 1411 regulations, there’s kind of a new
status as a net investment income tax real estate
professional.

Kirk: As a real estate professional, you need to have
one-half of your personal services devoted to trades or businesses
that are specifically enumerated in Sec. 469(c)(7)(C). There are 11
different ones. And you also need to spend 750 hours a year in those
trades or businesses, as well as being a material participant in them.
And then that turns off the per se status of rental real estate being
passive. All it does is that it allows the real estate professional to
then look at his or her real estate activities and test for material
participation.

So we got a lot of comments on the proposed regs. about real estate
professionals. A lot of people wanted real estate professionals
completely out—to just say that they are deemed to be in a trade or
business of rental real estate, in the event that they are a real
estate professional. And so, what we found was that since not all real
estate professionals are created equal, and not all rental properties
are equal, we couldn’t use real estate professional status as a proxy
for being in a trade or business. What we did was say was that if you
are a real estate professional under Sec. 469, that’s it, just as long
as you’re one, and if you spend more than 500 hours during the year on
one or more rental real estate activities, you will be deemed to be in
a trade or business. And the other part of the test is if you have
participated in that rental activity for 500 hours in five of the last
10 years—we borrowed the five-and-10 rule from the material
participation test.

Tell us a bit about self-rentals.

Kirk: What we heard loud and clear from tax
practitioners almost uniformly across the country was that it is a
very common business practice, and rightfully so, to keep real estate
and other significant-value property outside the operating trade or
business. And the Sec. 469 rules acknowledged that some 20 years ago
by treating self-rental as nonpassive income. For rent to be excluded
from net investment income, it needs to be nonpassive. So self-charged
rental in Regs. Sec. 1.469-2(f)(6) does that. But it also needs to be
derived in the ordinary course of a trade or business. And that part
was giving practitioners serious heartburn. So in the final
regulations, what we did, solely for net investment income tax
purposes, was, we deemed that property to be held in the ordinary
course of a trade or business, to get taxpayers over this second
hurdle. Because what we didn’t want was for taxpayers to be faced with
a choice of having to contribute property or otherwise change their
business structure solely because of a 3.8% tail that was wagging a
much larger dog.

Did the IRS have any specific goals for the net investment
income tax system? What was the big picture?

Kirk: My tag line that I used when I went out on the
road was that the IRS needed to make a system that was administrable
and that an individual could complete and satisfy their tax
obligation. If the only thing they had was a Form 1099 from their
stock brokerage account, if it was not administrable for those folks
and required a tax professional to be involved, then that’s a failure
of the system.

On the other end of the spectrum, for the persons, although few, with
the AGIs that are stratospheric, we had to make sure that the system
was not abused by them. We also realized that coming right down the
middle, where most of the rank-and-file taxpayers are, the closely
held business owners, could they be treated fairly and be able to
understand what their obligations are? That was the point. That’s what
the goals are.

To comment on this article or to suggest an idea for another
article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.

A CPA/PFS, David H. Kirk also holds J.D. and LL.M.
degrees and the CFP credential. Within the IRS Chief Counsel’s Office,
he specialized in federal income taxation of estates and trusts, S
corporations, and partnerships. Before joining the Chief Counsel’s
Office, he was an associate in the tax practice of Arnold & Porter
LLP in Washington. Before that, he spent eight years in the private
client advisers group of Deloitte Tax LLP, including two years in
Deloitte’s National Tax Office in Washington. In February 2014, he
left the IRS to join the National Tax Office of EY in Washington.

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